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A Ponzi scheme is a type of investment fraud that crosses state lines or involves financial institutions. This is a federal crime that carries the potential for long prison sentences and hefty fines. The premise of a Ponzi scheme is that investors reap big financial dividends with little or even no risk and a small to moderate initial investment. A company or individual who perpetuates a Ponzi scheme spends all of their time recruiting new clients in order to keep the scam going. Federal prosecution of Ponzi schemes requires specific elements of proof, and conviction of this crime may result in serious criminal penalties to all individuals involved in the scam.
Many people confuse Ponzy and pyramid schemes. A Ponzi scheme differs from a pyramid scheme in that the initial generations of investors in a pyramid scheme must recruit new clients. In a Ponzi scheme, only the perpetrator recruits new clients. The Ponzi scheme keeps the fraudulent activity to one or just a few individuals.
Although the name “Ponzi scheme” comes from criminal acts committed by Charles Ponzi in 1920, this type of crime is much older. Charles Dickens wrote “Martin Chuzzlewit” in 1844 and “Little Dorrit” in 1857, and both of these fictional novels included stories with this type of fraud. Around this time in Germany, Adele Spitzeder committed similar crimes, as did Sara Howe in the United States. Charles Ponzi’s scheme started in 1919. It involved the United States Postal Service. He set up a scam in which participants were to use international reply coupons in order to pre-pay for international postage. The person would take those coupons to their local post office in order to get the postage stamps required to send the reply.
At first, this wasn’t illegal. However, Ponzi became greedy and founded a company called Securities Exchange Company in order to expand his efforts. He promised early investors a 50% return on their investment within 45 days and a 100% return within 90 days. Instead of sending the investors their returns, Ponzi redistributed the funds and used them for his own expenses. The Boston Globe started to investigate this scheme in 1920 and brought it to the attention of federal authorities. On August 12, 1920, Ponzi was arrested on charges of mail fraud, which is a federal crime.
Although there is less reliance on the “snail mail” to commit fraud these days, the general characteristics of a Ponzi scheme are similar today to the original from just over 100 years ago. According to Investopedia, the general characteristics of a Ponzi scheme involve:
One of the most well-known modern Ponzi schemes that involved conviction by the federal government was perpetuated by Bernie Madoff. For more than 17 years, he operated an investment fund based on the Ponzi model. Before committing this fraud, Madoff was a pioneer in electronic investment trading, which gave him an air of authority and the necessary expertise to commit complex fraud.
In his scheme, Madoff attracted thousands of wealthy investors. He made billions of dollars over two decades of operating the scam. Madoff told investors that they would reap returns through a complex investment called a split-strike conversion. What he actually did was deposit the money into one savings account. When an early client wanted out, he used those funds to pay off their investment. He falsified records to make it look as if the investors were reaping large returns, but those returns were only on paper. Madoff was convicted of securities fraud, money laundering and other crimes. He was sentenced to 150 years in federal prison and died while serving his sentence.
A person operating a Ponzi scheme may face federal charges of mail, securities or wire fraud. The charges may also include money laundering, tax evasion and defrauding the elderly. In order to convict a person of operating a Ponzi scheme, the federal government must prove that the person committing the crimes intended to perpetuate a fraud. The government must also show that there was no legitimate way for all investors to reap the promised returns. The history of the scheme and its duration are also important factors in prosecuting this type of crime. These crimes are complex, and the government often spends years investigating them.